An article in the current week’s edition of the Economist asks whether one-and-ten will become the new two-and-twenty.

The discussion notes that there will be clear fee pressure on fund of funds. We will return to the question of fund of funds in a later post: as a quick precis of our views, while Madoff has raised long overdue questions about whether fund of funds really complete due diligence (saying no always gets in the way of making money) we still see plenty of room for fund of funds who genuinely can serve as expert intermediaries. Fund of funds as a provider of expertise rather than a provider of capacity, and, separately, fund of funds offering funds of managed accounts, both seem like valid models going forward.

For single strategy managers, the Economist makes several points in a single paragraph:

“Those funds with excellent records will manage to maintain their fee rates. Big diversified managers with mediocre performance will have to cut fees to hold on to their assets. Given the “high watermarks” in place, which require that losses be recouped before performance fees can be charged, they may struggle to retain top staff, although they should at least be able to stay in business. The real threat is to smaller operators—half of all hedge funds manage less than $100m. Lower management fees may not cover their fixed costs, such as salaries, accommodation and IT. The era of hedge-fund managers being unable to pay the rent may soon be dawning.”

While these points are valid, we remain very unconvinced by the argument that “those funds with excellent records will manage to maintain their fee rates.” More precisely, we agree that the largest funds with good performance will likely keep their fee schedules: but we are unconvinced that those fees are worth it when they are above 2 and 20.

If 2008 has shown us anything, it’s that – as we noted in our last post – you can’t rely on a “best of the best” hedge fund to deliver guaranteed performance.

Plenty of articles have been published commenting on the relative performance of some of the industry’s largest funds – Bloomberg in this piece commented on a variety of funds: while there were winners such as Paulson, Brevan Howard and Winton, there were also plenty of losers, notably Citadel. Another excellent Bloomberg article on Fortress noted that the firm’s Drawbridge Global Macro was down -26% while Drawbridge Special Opportunities lost 18%. This article from early November commented on performance from a number of funds: it only got worse by year end. Any hedge fund investor looking down their portfolio sees the same pattern of apparently random winners and losers among what were previously Top 100, star managers.

Ex post, therefore, some big funds funds have proved themselves to be worth their fees. Plenty of them, however, have proved not to be. Investors couldn’t predict the winners and losers beforehand during this market crisis: will they somehow be better at picking the big hedge funds that will be winners rather than losers when we have the next Black Swan event? Why should investors pay, ex ante, excess fees to any hedge fund based solely on a historical track record?

“This redirection of capital inflows [towards the biggest hedge funds] does seem to be driven by institutional investors. If we were to ask ourselves, however, what are the three most important issues for institutions considering a hedge fund allocation, we expect the answer would be:

1) Transparency
2) Fees
3) Independent oversight

But…the Top 25 hedge funds now receiving such large allocations of institutional capital have the most restrictive transparency, the highest fees and no independent oversight (virtually all do not appoint an independent administrator, meaning that investors must rely on the manager to calculate each NAV and price all the assets with no third party check.)

We’re really puzzled by this paradox – there’s obviously a big difference between what institutions say they want, and what they are prepared to invest in.

Why is this? Obviously, there’s strength in numbers, and it’s easy to justify an allocation to a firm if pretty much everyone else in the industry has already invested. But, to point out the obvious again, the Bear Stearns funds were run by the Wall Street house with the reputation for the greatest expertise in mortgage and structured securities available in the industry. Amaranth was one of the most sophisticated multi strategy funds available. Sowood was formed by superstar managers from the Harvard Management Company. Basis Capital in Australia had the highest possible, 5 star rating from Standard & Poors. The list goes on, and on.

The lesson, therefore, is simple and obvious: do not to take anything for granted. Certainly, asking hard questions – and being prepared to walk away – would have served potential investors in the above funds well. This is not the last time hedge fund investors will learn this lesson.”

Well yes.

As we noted nearly 18 months ago, the biggest firms typically have the highest fees, have limited transparency and often don’t have independent oversight over their NAVs. We would also add that it is typically the largest firms that ask for the longest lock ups: investors who signed up in ’06 and ’07 to 3 and 5 year lock classes must be pretty unhappy right now. Moreover, the biggest firms usually have the tightest gates and most restrictive redemption provisions in their offering documents: 2008 has shown that many (most?) of the industry’s largest funds have chosen to suspend redemptions, impose involuntary restructurings etc.

Where does that leave investors? We don’t deny that some of the largest hedge funds remain deeply resourced, highly skilled money managers. On the other hand, our point is not to write off the small guy.

For many reasons, we believe that there is a real value in being a “bigger fish in a smaller sea”. Thinking of operational issues, a larger investor in a smaller fund has so much more leverage:

Power to negotiate fees

Power to influence the terms of the offering document, and particularly to impact provisions related to gates, suspensions, side pockets etc.

Better operational transparency

Ability to engage in a constructive dialogue about operational controls: smaller funds are, for example, much more likely to have an administrator. Smaller managers typically also give more information about their procedures, enabling investors to get a better understanding of key controls such as valuation. Moreover, if a small firm needs to improve, they are much more likely to listen to a large, strategic investor – in fact, they are much more likely to listen full stop.

Investing in a smaller hedge fund – particularly now – gives the investor much better power to enter into that investment in a spirit of partnership. It also provides more flexibility on the way in and on the way out. That is massively different from going to a large multi strat and still facing an unappetizing menu of terms such as a 3 year lock class, a 8% rolling quarterly redemption provision, a 2 and 25, 3 and 30 fee structure et al et al.

One of the questions we always ask ourselves when we visit a hedge fund is about the culture of the manager. Put simply, does it feel as if the manager thinks we are doing him a favor by giving him our capital, or is there a sense that the manager feels he is doing us a favor by letting us in.

Right now, we would always pay less for a receptive manager than pay more for a fund which still thinks that that we need them more than they need us.